Family Business Succession Planning: Transfer Outright or In Trust?

Part 3 in a series…

As I begin the third post in this series on family business succession planning, let me first say that I bring to the subject both personal experience and some ambivalence.

In 1984, a few months after I graduated from college, my father, the fourth generation of the Renkert family to run the business and the largest shareholder, transferred his shares to a Charitable Lead Annuity Trust (or, to use the estate planner’s acronym, a “CLAT”). At the end of the annuity period some 7 years later, the shares passed to trusts for the benefit of my two brothers and me. During the decade from 1993 to 2003 when I was president of the Company, I was working for the trusts. Since my return to practicing law, I’ve helped many clients structure trusts to hold assets, including shares in family businesses, for the benefit of their children and further descendants.

Wearing my lawyer’s hat first, here are some of the virtues of transferring interests in trust:
• Legal ownership is separated from beneficial ownership – with a trust, a trustee owns and manages trust assets for the benefit of family members who might not be capable or willing, whether due to age, insufficient education or lack of interest.
• Interests are protected from beneficiaries’ creditors, or more concretely, if a beneficiary gets divorced, injures someone in a car accident, declares bankruptcy, or otherwise is subject to the claims of a judgment creditor, the creditor likely won’t be able to get the shares held in the trust.
• Business interests can be removed from the transfer tax system in perpetuity, at little or no tax cost. With careful structuring and use of the transferor’s lifetime gift, estate and generation-skipping tax exemptions, interests in the business can pass to future generations free of gift, estate or GST tax. In contrast, transfers outright potentially are subject to potential estate and gift tax at each successive generation.

OK, so what’s not to like? Both from observation and personal experience, many of the protections and benefits offered by a transfer in trust can stick in the craw of a successor.
• The trustee, not the beneficiary, has the ultimate power – to vote in directors, to consent to or reject major business decisions (such as to borrow money or sell the business or a division), and often, to make or withhold distributions to the trust beneficiaries. I have an excellent working relationship with the trustee of my trust, but being a beneficiary is simply not the same as owning the assets outright.
• You’re working for the trustee, not for yourself. Where is the incentive to outperform? We’ll get to compensation later in this series, but in the meantime, I believe that successors who have some skin in the game, whether in the form of shares, phantom stock or a well-crafted bonus plan, are more motivated than those who just pull down a paycheck (no matter how outsized that paycheck may be). When my brother took over managing the business, the board structured a stock bonus plan by which he earned a stake in the Company, giving him greater control and stronger incentives.
• The transferor (your parent) didn’t trust you enough to transfer the business to you outright. Trusts are great tools, but their complexity and formality are daunting to successors. Too many transfers are engineered by a parent and a lawyer without the knowledge or participation of the successor. Too often, without clear communication and preparation, the parent’s intentions and objectives in transferring the shares in trust can be misconstrued by successors. (My dad was very clear with us about his intentions, so this isn't a concern I've voiced personally, but I have met a number of beneficiaries who were troubled by their parents' decisions.
• The trustee is more concerned about the beneficiaries than the business. Families who transfer businesses in trust need to recognize that a trustee has a legal duty to manage trust assets for the benefit of the beneficiaries, and this duty can trump the family’s desire to perpetuate the business.

If we could travel back in time to 1984, and I could meet with my parents and their estate planning lawyer, would I urge them to throw away the trusts and give us the shares of the Company outright? While it might have been simpler just to own the shares, my answer is No. Working for the trusts fostered in me a sense of family stewardship – that I was working not just for myself but for my siblings and our children. Reporting to a trustee at annual shareholder meetings - honoring corporate formalities – forced me to plan more carefully, and to articulate performance and strategy more clearly. The discipline of dealing with a third party owner made me a better manager.

Family Business Succession Planning: Who gets the interests?

Part 2 in a series…

Who gets the interests* in the business? Only family members who work in the business, or every member of the next generation?

While much depends on the particular circumstances of the family and the business, some thoughts:

What’s fair?

Fairness is in the eye of the beholder: transferring an equal slice of the business to each member of the next generation is not inherently more equitable than transferring a controlling interest to one and a participating but non-controlling interests of equivalent value to others, or than transferring the business to one and non-business assets of equivalent value to the others. The key phrase in the previous sentence obviously is “of equivalent value”, and it is worth considering sources of non-financial value conferred by a family business when thinking about allocating assets.

Who will care for the business?

Is the next generation committed to tending to the business in some capacity – whether as owner-managers, as board members, or as active shareholders? The past success of the business can’t continue without interested, capable, and active owners, and even if the next generation member doesn’t participate in the business on a day-to-day basis there is considerably more for an owner to do than collect dividends or distributions. Long before ownership is actually transferred, the next generation needs to begin learning about the rights and responsibilities of ownership, so that when and if the time comes for them to assume ownership, they do so with eyes wide open.

If one child has managed the business for years, while others have successfully entered other occupations, the obligations of shared ownership may be an unwelcome burden to the non-managers. In this case, it may make more sense to gift or sell the business to the family manager, and then allocate non-business assets among all the children. If management of the business will rest on the shoulders of one family member, while ownership is transferred to the next generation as a group, developing clear and accepted governance procedures will be critical. Do all parties understand and respect the rights and obligations of management? Of the directors? Of the owners?

What if the next generation isn’t interested?

If there is no interest or participation by the next generation in the business, selling the business to a third party may make more sense than keeping it. Blasphemous? Maybe to some families, but ironically, selling the family business may be what enables the family to further its legacy in other areas. A sale can free up capital to enable the next generation to invest in new business ventures or philanthropic efforts. If the senior generation is ready to transfer the business but the next generation simply isn’t old enough or experienced enough to take over the responsibilities of ownership, transferring ownership in trust may be a worthwhile option to consider…more on that topic coming up.
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*By “interests in a business” I mean shares in a corporation, partnership interests, LLC membership interests, an undivided interest in real estate - an interest in the family enterprise, however that may be structured for legal purposes.

Family Business Succession Planning: Why Now?

This post begins a series on transferring ownership of family businesses to the next generation. Along the way we will think about the following issues:
• Transfer now or later?
• To family managers only or all members of the next generation?
• Outright or in trust?
• By sale or gift?
• Governance after the transfer – the importance of an effective board
• What if the next generation isn’t ready?
• Clarifying the returns to owners and managers: structuring an appropriate compensation system post-transfer.

Transfer now or later?
For most family businesses, the better answer is “Now”. Why?

Hit by a bus? Now what? One of the biggest risks to a privately-held business’s continued success is the sudden death or incapacity of an owner/manager. Without the boss around, employees lose focus, or worse, panic. Customers, fearing an interruption in supply or decline in quality, seek other suppliers and buy less. Vendors may cut back credit terms; banks may call the business’s loans. On the other hand, if ownership has been transferred (or a funded buy-sell agreement exists), an effective board of directors is in place, and there is a clear management succession plan, then the successors can step into their new roles quickly, stakeholders will be reassured, and day-to-day operations can be restored.

Death and taxes. The business owner who waits to transfer shares at death puts the business at significant risk – planning for a catastrophic event on an unknowable future date can be perilous. Remember that 9 months following the date of death, the estate will owe a 45% tax on the amount by which the value of the owner’s assets – including the shares – exceeds $3.5 million (assuming no major change in the estate tax exemption comes out of Congress). If provision has not been made to ensure there is enough liquidity available to the estate to pay the taxes – whether via a buy-sell agreement, insurance trust, or creation of a fully liquid side fund – the business may have to be sold to pay the taxes. Transferring the shares to the surviving spouse at death, either outright or in a QTIP trust, will defer the tax liability, but can create unexpected control and cash flow issues, particularly if the surviving spouse is not involved in or supportive of the business. By transferring the shares during lifetime, the owner can insulate the business from the estate tax liability.

Valuation opportunities. The current recession has created unprecedented opportunities to transfer ownership of a business cost-effectively. Business valuations are unusually low right now, both because of business-specific issues (for most businesses, sales, profits and cash flow are well off previous highs) and larger economic issues (fire sales of risky assets in the wake of the banking implosion mean that the stock prices of public companies most often used by valuation firms as comparables are also well off previous highs). As a result of these trends, the economic and tax costs of transferring shares within families are unusually low. Families should be aware that the window of opportunity may be closing as the recession ends and business conditions improve.

But how am I going to pay the bills? Perhaps the biggest reason owner managers don’t transfer businesses to the next generation is that they depend on income from the business for living expenses. Thoughtful planning can avoid or minimize this problem. First, the owner doesn’t have to give the business to the next generation - the business can be sold on an installment basis, creating a steady stream of income for the selling owner without saddling the new owners with an unmanageable financial obligation. Second, the selling owner can continue to be employed by the business in an executive or advisory capacity, or can enter into a non-compete agreement that ensures a second stream of income. The selling owner can purchase a life insurance policy – or better yet, create an irrevocable life insurance trust (ILIT) –to provide for his or her surviving spouse. If the owner simply cannot afford to transfer all of his or her shares, another option might be to spin off the business’s real estate into a separate entity, and keep the real estate while selling the operating business. The real estate entity would then rent the real estate back to the business, generating an additional income stream. This option permits the owner to accomplish the transfer of the operating business while still keeping a significant financial interest. (We’ll revisit this option when we discuss who should own the business, and how to deal with control issues.)

And what will I do? Beyond financial concerns, some founding owners consciously or unconsciously dread transferring control to the next generation because they fear losing their identity. There is no simple solution to this problem, and all stakeholders need to be aware that transferring a business is not just a financial transaction. Families struggling with this issue may want to bring in a consultant/therapist well –versed in family-business dynamics to assist them through the transition. Generally, succession is most likely to be successful when an owner chooses to transfer his or her shares and is an active participant in a thoughtfully-planned succession process.

Next week: Who should own the business – only family managers or all members of the next generation?

Holiday Thoughts on Love and Money

When it comes to estate planning, what do prospective beneficiaries really want? If you answered “THE MONEY”, think again.

Consider Betsy, the youngest child of Sarah (now 80) and Henry (now deceased). (Names and identifying details have been changed to protect clients’ privacy.) Henry married Sarah after the death of his first wife, Faith. Sarah helped to raise Henry and Faith’s children: Andrew (now 63) and Alex (now 60 and married, with a 12 year old daughter, Clare). Sarah and Henry also had two children of their own, Brian (now 50) and Betsy (now 47).

Alex was 13 when Betsy was born. Alex loved having a little sister and doted on Betsy as she grew up, watching her gymnastics meets when he was home from college and driving her and her friends to the movies and the mall. He hosts family birthday dinners for her every year – and never puts more than 21 candles on the cake. Betsy in turn dotes on Alex’s daughter, Clare, attending her ballet recitals and soccer games, and taking her to plays and concerts.

A number of years ago, Sarah consulted her lawyer to develop an estate plan. When Henry died in 1990, he had left half of his assets to a trust for his children, and the balance – an investment portfolio, a New York apartment, and a home in the Connecticut suburbs – for Sarah. The trust investments had performed well and helped to augment all four children’s incomes. Since the older children were well-provided-for, Sarah’s lawyer suggested that she might wish to focus her own planning on her two children, Brian and Betsy. As part of the resulting plan, Sarah contributed the Connecticut house to a Qualified Personal Residence Trust (“QPRT”) for their benefit. By using a QPRT, Sarah was able to transfer the house to her children using very little of her lifetime gift tax exemption, while retaining the right to live in the house for a number of years.

Earlier this year, the Connecticut house was sold and Brian and Betsy each received a six-digit distribution from the QPRT. When Betsy learned that Andrew and Alex had not received the same benefit, she asked her mother to change her will to “even up” the distributions among all four of Henry’s children. After some very difficult conversations, Sarah did as Betsy asked.

With the changes to Sarah's will, Betsy will receive substantially less when her mother dies. Altruism? No – Betsy will tell you she acted primarily from self-interest: she feared that when Andrew and Alex learned that Sarah had favored Brian and Betsy in her planning, their vision of themselves as a family unit would be damaged, and their relationship with Betsy might become strained. Betsy and Brian are not close, and besides her mother, Andrew and Alex and their families are Betsy’s support system. To Betsy, the risk of losing Andrew, Alex and Clare worried her far more than inheriting less of her mother’s estate.

Estate planning is not just about dividing up the money and the assets. Financial allocations create non-financial consequences which deserve thoughtful consideration. Simple scenario planning – even just envisioning future Thanksgiving dinners – can help families and planners uncover the unexpected consequences of an estate plan for all family members. At Fisher Renkert LLC, we have extensive experience developing sophisticated, tax-efficient, cost-effective plans that also take future Thanksgiving dinners into consideration.